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Making Price Ratio Valuations Work for You

Warren Buffett's primary investment strategy over the years has been one of value investing; namely, looking for stocks where the current price is low considering the intrinsic value of the

Warren Buffett’s primary investment strategy over the years has been one of value investing; namely, looking for stocks where the current price is low considering the intrinsic value of the underlying company. Now, to be clear, if there were a simple, reliable measure of “intrinsic value” out there, there wouldn’t really be any need for an article like this. Alas, that isn’t the case. However, there are several measures that gauge the price of a particular stock against data that could be indicative of intrinsic value. This data can be especially useful when looking at small-cap companies.

Price to Earnings Ratio

Typically referred to as P/E Ratio, this number is calculated by dividing the market price of one share of stock against one year’s EPS, or earning per share, which is a company’s profit divided by the number of shares. In essence, this is a way of measuring the ratio between what people are paying for a stock against how much money it’s actually bringing in. P/E ratios can also be expressed to take into account past performance against guidance for future performance. P/E ratios calculated with the last 12 months of data are referred to as trailing P/E, while P/E for the next four quarters is called Forward P/E, and a third variation takes the last two quarters along with the next two quarters.

Price/Earnings to Growth Ratio

Also referred to as the “price multiple” or “earnings multiple,” P/E ratio is not the silver bullet it might initially appear to be. A start-up company with great potential may have a lousy P/E ratio as the company fails to turn a profit right out of the gate while still boasting excellent long-term prospects once the company picks up speed. As such, the price/earnings to growth ratio, or PEG ratio, can be another very valuable offshoot of P/E ratio. PEG ratio is calculated by dividing P/E ratio by annual EPS growth. As such, PEG ratio takes into consideration both P/E ratio and the growth of a company, and is often a more popular metric to consider. Like P/E, a low PEG ratio is desired.

Price to Cash Flow Ratio

While earnings and growth are one thing, cold hard cash is another entirely. As such, one may also want to consider the Price to Cash Flow Ratio, calculated by dividing the market price of the share by the company’s total cash flow per share. By doing this, P/C ratio can provide some insight into a company’s cash assets and how much cash a company is bringing in when measured against the share price.

Price to Free Cash Flow Ratio

And further down the rabbit hole we go. While P/FCF ratio might sound fairly redundant, it does serve its own specific function. Free cash flow, which is cash flow minus capital expenditures, accounts for expenses a company might have that would limit the value of its cash flow. As such, P/FCF can sometimes paint a more nuanced picture of a company’s relative health.

Price to Sales Ratio

Price to sales ratio is very similar to price to earnings and a fairly simple measure, calculated by dividing the share price by the revenue per share of the company. Total revenue differs from earnings in that it doesn’t take into account any expenses the company must pay, whereas “earnings” can be considered what’s left of that revenue once all the bills have been paid.The price to sales ratio is geared towards total revenue and can vary widely from industry to industry, so many experts prefer using price to sales when looking at multiple companies from the same industry or segment.

Caveat Emptor

As stated earlier, if picking stocks were as easy as looking at these five numbers, every investor out there would be rolling in money. Unfortunately, there’s always a lot more data to consider before investing in any company. These five stats can be employed to help hone in on appealing stocks by looking at the potential for that “intrinsic value” that can exist behind the numbers, especially for small-cap stocks with less information available.

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